Tuesday, May 13, 2014

Should I buy more high yielding stocks in order to retire early?

Most readers know I focus on dividend growth stocks, which are companies that tend to grow distributions every year. I search for companies that typically yield more than 2.50%, have demonstrated growth in earnings and dividends over the past decade, and have a strong foundation that can support further distribution growth.

However, I do focus on a lot of companies where average yield is somewhere in the 3% - 4% range. These companies have sustainable dividends, and dependable dividend growth rates, that are very likely to exceed 6%/year for the next decade.

Some readers have asked me however, why don’t I merely focus my attention on higher yielding stocks, that pay anywhere between 6% – 8% today, and speed up my financial independence. I could load up my portfolio with companies like:

Kinder Morgan Energy Partners, L.P. (KMP) operates as a pipeline transportation and energy storage company in North America. This master limited partnership has managed to increase distributions for years in a row, and currently yields 7.50%. Check my analysis of Kinder Morgan.

American Realty Capital Properties, Inc. (ARCP) owns and acquires single tenant, freestanding commercial real estate that is net leased on a medium-term basis, primarily to investment grade credit rated and other creditworthy tenants.This real estate investment trust has managed to increase dividends for years in a row, and currently yields 7.60%.

Realty Income Corporation (O) is a publicly traded real estate investment trust. It invests in the real estate markets of the United States. This real estate investment trust has managed to increase dividends for years in a row, and currently yields 5%. Check my analysis of Realty Income.

If a real estate investment trust (REIT) wants to buy an apartment complex that generates an 8% yield, it might not be a very good idea to issue stock or debt to investors that yields more than 8%. However, even if they end up paying a lower yield on equity or debt, but they need to refinance that debt in a few more years at higher rates, this could be bad for dividend incomes. The problem with most high yielding companies is that they are pass through entities, which essentially share all of their free cash flows with investors, by sending out fat dividend checks. This leaves those companies exposed to hiccups in financial markets, which are vital for their growth and for access to capital.

In addition, there is always the increased risk that those pass-through entity structures are abolished by the Tax authorities. With a pass-through structure like a REIT, master limited partnership (MLP), or a Trust, there is no taxation at the entity level. All the taxation occurs at the individual shareholder level. In comparison, corporations like Coca-Cola (KO) pay taxes at the corporate level, and then individual investors pay taxes on dividends they receive in taxable accounts. This is why pass-through entities like Realty Income, American Realty Capital Properties, Kinder Morgan Energy Partners can afford to pay such fat dividend yields – they essentially do not pay income taxes and rely on capital markets for capital on capital spending, and acquisitions. However, if the revenue starved governments decides to get a higher share of the tax mix, they could start taxing those entities. This would effectively reduce attractiveness of pass-through entities, lead to steep dividend cuts, and losses for investors.

This is why I believe that there is generally a higher risk of a dividend cut with high yielding stocks.

In addition, there is a high risk of lack of dividend growth. This will reduce purchasing power of my principal, and result in constant downgrade to my lifestyle.

I also believe that by owning a portfolio consisting predominantly of pass through entities, I am taking a concentrated risk, which is contrary to the ideas of diversification I have been preaching on for the past six –seven years.

If I needed $30,000 in annual dividend income, but only had a portfolio worth $500,000, I could do two things. The fist is to design a portfolio with an average yield of 6%, and call it a day. The second thing would be to invest in a mix of more reasonably priced companies, wait for a few more years of savings and patiently compounding my capital before achieving my goal. The risk with the first scenario is that those higher yielding stocks stop growing dividends, which would reduce purchasing power of my income. In addition, if there are dividend cuts, my lifestyle would be even worse off. If you need $30,000 to live on in year one, you would likely need $30,900 in year two assuming a 3% inflation.

What good is a high dividend stock that yields 6% today, if it gives me a 50% chance of a dividend eliminations within next decade, compared to a stock yielding 3% that has only a 10%-15% chance of a dividend cut. If I earn 6% this year, but next year I get a 50% dividend cut, I am not better off eventually than an investor who started out with a 3% yield that was unchanged in year two. As an investor, my goal is to maintain and increase my real income, and only suffer the least amount of losses. If I just focus on the yields today, I might end up missing out on the risks I am taking in the process.

With a more moderate dividend growth stocks yielding somewhere between 2.50% - 3.50% today, I have a better chance of reaching my goals, having a sustainable income stream, and a better fighting chances against dividend cuts and inflation.

I believe that I only need to get rich once. Therefore, my goal is to be patient, and build my dividend foundation slowly and carefully, rather than be in a hurry, and avoiding excessive risks.

19 comments:

I think DGI has put forward a well-reasoned argument, but it's also one filled with many IFs... IF this, IF that. It also puts forward the notion (ill-advised I agree) of a dividend portfolio dominated by the higher yielding holdings such as KMP, ARCP and O.

What the post doesn't envision, though, is a balanced and diverse dividend portfolio that has some 2 and 3% dividend growth stocks, along with some higher yielding REITS, MLPs and similar holdings that have long and quite good track records of consistent and growing dividend payments.

Failing to recognize that as a reasonable approach is, to me, the failing of the post you've made here.

Yes, the federal government could change the tax structure for REITs and MLPs. But I'd argue the likelihood of that is less than the chances of, let's say, low-yielding Target failing to expand well internationally, or Family Dollar stores having a terrible earnings slump and announcing plans to close 370 stores.

So I guess I'd argue, the best-of-breed high-yield holdings aren't necessarily any riskier than the general risks associated with other generic, lower yielding stock market entities that have to deal with changing markets, other competitors, economic conditions, etc etc.

Well, the reality is that few investors are good at predicting future events with any sort of accuracy. The problem with pass through entities is that a single event like high interest rates and difficulty in accessing capital markets could bring down otherwise pipelines or REITs or BDCs down on their knees. Plus, never assume that the government can or cannot do something - just look north of the border and check what happened to Canroy investors.

But there is risk everywhere in everything. The risk to think about is permanent impairment of capital and income, not temporary problems. So for TGT and FDO, those issues experienced in 2013- 2014 could be a sign of more trouble ahead or just a temporary problem. Either way, we would not know for sure until several years from now.

Anyway, you might like this article about layering dividend yields/growth - http://www.dividendgrowthinvestor.com/2010/04/three-dividend-strategies-to-pick-from.html

Having 10% of a portfolio in REITs (not MREITs), is just good diversification, and having another small portion in MLPs, is fine too, especially in a tax advantaged account. This would eliminate many of your concerns, and provide diversification.

I read the linked "my dividend retirement plan" and have a quibble with it. You seem to compare today's present value of expenses to the nominal growth of future dividends. Wouldn't a more conservative approach involve using real dividend growth rates which would probably extend for a few more years the financial independence goal? I have read that the long term real (inflation adjusted) dividend growth rate is about 1.5%. Obviously, some years higher, some lower. Your assumptions seem overly optimistic. Sorry, I can't cite the source right now, but it is a number seared into my brain.

Well, the target amounts in 2018 are adjusted for inflation. For example, if I needed $85.90/month for cable in 2013 and my only expense was cable, my target would have been to have $100 in income by 2018, assuming a 3% annual inflation rate. Therefore, the estimates showing nominal returns provide for an apples to apples comparison.

Of course, those are all estimates, and the reality could be much better or much worse. Everyone was predicting high inflation in 2008 - 2010, yet it never materialized. Hence, I don't do predictions, I just try to think probabilistically.

I agree. My stock portfolio mix with high yields and low yields, and when I calculate stock gains over the last two years, I realized that high yields stocks stay at the same price for last two years, but the low yields (1.5 % to 4%) stocks performed well and increased their distribution few times.

The real kicker is performance over the next 20 - 30 years. I try to pick companies that I can hold for 20 - 30 years, without having to monitor them as closely as an investor in TSLA or TWTR would have to monitor their holdings for example. I will surely have losers, but I expect that on average I would come out ahead.

I agree with others: diversification is the key here. It is always wise to allocate SOME funds to REITs and MLPs. It is stupid to have only REITs, only MLPs or only Dividend Aristocrats. Mix them and you are in the safer zone.

DGI, did you forget the usual full disclosure? I'm long KMI, ARCP, and O, but the total in MLPs is 3.2% and in REITs is 3.3%. I agree that higher yields are indicative of greater risk, but I think all of the listed companies have fairly good prospects going forward. The government is another story, and you only have to look at what's happening in Europe to see what desperation does to taxes. Another nice article.

I did forget, so I updated the disclosure. Need to cut down on Diageo products, I suspect.

I am not sure whether there will be an overhaul to the tax system or not. The way I see it, odds for dividend stability are not very good for pass-through entities in the next 20 years relative to odds for regular dividend growth corporations. Of course, I try to see things from a perspective of someone who builds a portfolio and then does nothing else but collect the dividends ( although I do a fair bit of monitoring).

The three companies I mentioned do have good prospects, which kind of detracts from my message to not concentrate too much in high-yielders. Bummer..

I fully agree with your analysis. I always favor lower yielding but higher growth dividend stocks with "normal" payout ratios than the current high yielding stocks of today with payout ratios over 100% like KMI. My entire portfolio is built on that premise. I often wonder why many in the blogging community put so much of their money in 5%+ high yielding instead of a 2%-3% stock like an AFL but has increased dividend over 16% annual the last decade.

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